Not All Bubbles Lead to Depressions

I enjoyed the opinion piece in yesterday’s WSJ, From Bubble to Depression? I want to clear up a few of their misconceptions.  Key quote:

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

They almost get it in their later paragraphs, but the answer is simple.  In the first “crash,” the losses were mainly equity-based, so there were no knock-on effects on other entities.  No additional dominoes fell.  With housing in the late 2000s, a loss of $3 billion happened on assets that were usually levered with debt at 5x to 30x, probably averaging 10x.  And, these mortgages were held by leveraged banks that had borrowed in many other places in the overall financial system, and sometimes by even more leveraged speculators using CDOs.

Let me say it again — Bubbles are financing phenomena; depressions are financing phenomena.  They are opposite sides of the same coin.  The severity of bubbles differs with the amount of debt employed and the pervasiveness of the sectors of the economy affected.  The tech bubble did not have much debt, and it was contained.  The real estate bubble was the opposite.

The thing is, the amount of debt we have racked up as a fraction of GDP exceeds that of the Great Depression.  My view is that many debts will have to be liquidated before the US economy grows robustly again, whether through payoff, compromise or inflation.

Now, we had Michael Mayo today offering his opinions on the banks, (two, three) which are not all that much different than mine.  In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation.  Better not to try at all.  An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.

This last bubble has led to a depression, because of the debts incurred.  We must liquidate debts, but in the process, the economy will suffer.  I’m sorry, I like prosperity too, but there is no way out of this period of debt liquidation.  Just as the period of debt growth pushed asset prices up, so the period of debt deflation will push asset prices down.

My advice?  Avoid almost all banks, and other financial companies sensitive to the stock market or real estate, in terms of both equity and bond investments.